Understanding an Insurer's Balance Sheet

Insurance companies are magical creatures that, in the hands of a skilled operator, perform alchemistic feats and literally mint money. However, reading and understanding their financial statements are a little difficult, so let's try to break this task down into bite-sized chunks. First we'll get familiar with the terms and calculations; later on, we'll see how the statements are linked and flow into each other.

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Balancing Sheet Act
Insurance companies are balance-sheet-driven businesses, so we'll start here with the assets. Let's look at the 2005 balance sheet assets of two auto insurers, Progressive (NYSE:PGR) and Mercury General (NYSE:MCY).

2005 Assets (Millions of Dollars)

This is way too complicated, so let's make some simplifications. We'll group all investments (bonds, stocks) into "investments" and throw cash in there as well. Then we'll make a category called "policyholder money we don't have yet." This refers to:

• future premiums to be received (premiums receivable)
• money that the reinsurers owe (reinsurance recoverable)
• money already paid to reinsurers for future reinsurance policies (prepaid reinsurance premium)
• money already paid -- but not expensed yet -- such as agent commissions and premium taxes, to acquire policies (deferred acquisition cost).

Everything else we'll call "other assets." (PLEASE -- when investing in an insurer, read the footnotes -- I'm simplifying here for clarification purposes)

Our simplified balance sheet reads:

Now that you've got the hang of how I'm simplifying things, we'll reduce liabilities and shareholder's equity. First, we see "policyholder money we have" -- made up of:

• unearned premiums (policyholder money paid for future coverage)
• loss and loss adjustment expense (policyholder money set aside for already incurred losses, incurred but not reported losses, and the cost of settling claims)
• other policyholder liabilities

We also have "debt," which is made up of -- you guessed it -- debt, and "other liabilities," made up of items such as accounts payable and accrued expenses. Finally, there is shareholder's equity (assets minus liabilities, similar to liquidation value). Our simplified balance sheet looks like this (to make this even more readable, I am reformatting numbers in billions):

Simplified 2005 Balance Sheet (Billions of dollars)

The first thing to note here is float. In a nutshell, float refers to the money that policyholders give to insurers in return for insurance. With our simplified balance sheet, calculating float is simple:

Float = Policyholder money we have - Policyholder money we don't have yet

In this case, we can see Progressive has about $6.5 billion in float, and Mercury has roughly $1.5 billion. We can also see "Other Assets" and "Other Liabilities" are about equal, so we'll net and ignore these. Lastly, we have debt and shareholder's equity value.

Thus, we have three main pieces that comprise the balance sheet (ignoring other assets and liabilities, which we've netted out): float, debt, and shareholder's equity.

The reason I simplified to these three points is because each of these represents the different pieces of financing: float is money provided by policyholders, debt is provided by creditors, and shareholder's equity (estimated liquidation value) is provided by equity holders.

Back to basics
An insurer takes money from these three sources of funding (policyholders, creditors, and stock holders) and invests it. If we take Progressive's float ($6.5 billion), debt ($1.3 billion), and shareholder's equity ($6.1 billion) we get $13.9 billion -- notice this is about equal to Progressive's $14.3 billion in investments. In other words, an insurer takes money from policyholders (float) and creditors (debt), and pays out operating expenses, claims and claims expenses, and interest payments. The remainder is left over for the stock holders and taxes -- this money is reinvested into investments and increases shareholder's equity, which increases the value of the insurance company to stock holders. However, if the insurer is taking bad risks it'll end up owing a lot of claims (if the losses fall to the bottom line, this eats into shareholder's equity) -- the money to pay out claims comes out of float and investments, which is bad.

By now it should be clear what drives an insurer's balance sheet value: the more shareholder's equity and float, the better. (Quick note: In the short run, if an insurer under-prices its policies it can grow premiums and float very quickly; in the long run losses will eat up the float and shareholder's equity. Watch out for the fools that rush in.) Progressive's $6.5 billion in float (at the end of 2005) and $6.1 in estimated liquidation value were valued at $21 billion. Mercury General's $1.5 billion in float and $1.6 billion in liquidation value were valued at $3.2 billion at the end of 2005.

Hopefully this provides a simplistic and clear understanding of the different pieces of an insurer's balance sheet. Later on we'll look at the other financial statements and link them together to see how an insurer creates or destroys shareholder value.

For some other insurance commentary, check out:

• Getting to Know the Insurance Industry
• Insurance Industry Basics: Float
• Rounding the Second Curve Part 2

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above and appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.